Learn About Investing
Investing isn’t for everyone. But if you have thought about whether you should invest and the answer is yes, you need to build an investment portfolio. That sounds rather grand, but it just means getting together an appropriate collection of investments to suit your needs.
What is the right mix of assets then? There is no simple answer. For a start, it all depends on your personal circumstances. Also, no one knows how each type of asset will perform in future. So where on earth does one start?
What not to do
A good place to start might be with what not to do! In practice, many investors build up a rather motley collection of investments over the years. Maybe shares in companies they’ve bought after hearing tips from friends and relatives. Or perhaps investments based on gut instinct alone.
Unfortunately, investment portfolios that have evolved in such a higgledy-piggledy way are less likely to meet your needs. Moreover, grounding your decisions on gut emotion is also likely to be unhelpful – because emotional biases get in the way of effective investing.
Unlikely though it sounds, establishing an effective football squad may not be so different from building a sensible investment portfolio. The central point is that it’s not just about individual talent. It’s about blending individual elements to create a team that works together, to achieve a common objective.
An effective team – or investment portfolio – is one where the whole is greater than merely the sum of the parts. The aim is to maximise returns while minimising risk. After all, it’s no good scoring lots of goals if you let even more into your own net.
As with football then, there is no single answer. Overall, your portfolio should reflect an appropriate level of risk. This is based on a number of factors, such as your age, wealth and attitude to risk.
If a football team needs an appropriate mix of talent, from strikers to goalkeepers, what is the equivalent when investing?
"A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies."
Harry Markowitz Nobel Laureate in Economic Sciences
To stretch the metaphor, it goes beyond avoiding relying too much on one individual in a single position. It’s about maintaining a squad that can draw on a suitable mix of roles - strikers, midfielders, defenders and goalkeepers – generally.
In similar fashion, a well-balanced investment portfolio helps manage risk through diversification. And this isn’t just about having diversity within one asset class – for example by holding shares in lots of different companies – but by diversifying across different types of asset. A football manager is unlikely to want a team made up entirely of midfielders, after all.
The reason for this is that the values of different asset classes don’t tend to move about in sync. The property market may be going down while shares boom on the stockmarket, or vice versa. It makes sense to gather a team of assets together that don’t all move in the same direction at the same time.
So, a central concept defining each portfolio is the proportion in which different asset types (or asset classes) are blended together. In financial jargon, this is called asset allocation.
If prices of two assets move in step together, they are said to be ‘positively correlated’. Negative correlation between two assets means that if one goes up in price, the other tends to go down. Uncorrelated assets, meanwhile, show no discernible connection.
While most people wouldn’t mind seeing all their investments zoom up in value at the same time, few want to see them doing the opposite. So, one important aspect of many investment portfolios is to seek low (or negative) correlation between some of the assets.
This means that if some investments are doing poorly, at least others are probably faring better. What’s more, if the market for one asset class is depressed – potentially enabling you to pick up some bargains – it could give you the option of selling a different asset class (to pay for them) while it’s riding high.
Regrettably, there is no guarantee that correlations of the past continue to hold in future. Shares and bonds are two components of many investment portfolios. In part, this is because of the low correlation between them most of the time. But there have been periods when this wasn’t the case.
Indeed, one of the features of a major financial crisis – as occurred in 2008 – is that assets which aren’t usually correlated can suddenly all plunge in price at the same time. In practice, finding lots of assets with no correlation, or high negative correlation, is difficult.
Rebalancing your portfolio
The job of creating an investment portfolio doesn’t stop with a ‘strategic’ decision about asset allocation. There are ‘tactical’ considerations to take into account. An important one of these is keeping an eye in the various investments within the portfolio to make sure that the ‘strategic’ plan isn’t getting out of kilter.
A simple example: if a portfolio is intended to comprise of 60% shares and 40% bonds, over time one of those two asset types will have outperformed the other. This means that the 60:40 proportion has shifted to become 68:32 or some.
As such, it is common practice to rebalance your portfolio. In this example, this would involve selling/buying assets to get back to the 60:40 mix originally intended. Financial advisors suggest rebalancing portfolios every year or two. (Some recommend doing it as frequently as every quarter, though others argue that this is overkill).
Rebalancing can feel odd, given that you may find yourself selling recent ‘winners’ and buying ‘losers’. But to return to the football metaphor, it’s more like resting a star player on the bench for fear they are about to burn themselves out.
Other tactical issues may also affect the make-up of an investment portfolio, not least being tax considerations. It is important these are taken into account as changes in your circumstances, or to tax rules, could prompt tweaks to a portfolio.
Common investment portfolios
The theory is all very well, but what should an investment portfolio look like in practice? Switching from football to clothes, people clearly come in different shapes and sizes, both physically and financially.
The most desirable option is likely to be a portfolio carefully tailored to your individual needs by an Independent Financial Advisor or other professional. And then to have it trimmed (or rebalanced) periodically.
The portfolio of a wealthy 64-year-old, approaching retirement, is likely to involve a very different mix of investments from a 20-something-year-old just starting out in the workplace. Sadly, bespoke financial tailoring comes at a price, but as with clothes, ‘off the peg’ solutions are also available. These may suit your needs perfectly adequately, even if they don’t provide an exact fit.
Finance professionals can provide specific advice on suitable portfolios, but these three common types of portfolio give you a flavour of how it’s done in practice:
- 60:40. This is as plain vanilla as it gets. In this ‘classic’ investment portfolio, 60% is invested in shares and the rest in less volatile assets such as Investment Grade bonds or cash. In past decades this mix, give or take 10%, was ‘standard issue’ for many investors. As with other ‘classics’, it’s unlikely to go out of fashion any time soon. Fans include legendary financiers, such as Jack Bogle.
- Model portfolios. Over time, it has become easier for everyday investors to acquire a broader range of assets – from property to commodities. Reflecting this trend, various new ‘template’ portfolios are recommended by financial advisers, or even bloggers. These throw additional ingredients into the investment mix. A few of these ‘model portfolios’ have gained notable popularity and may at times outperform a simple 60:40 share/bond split.
- Modern Portfolio Theory (MPT). This mathematical approach to investment portfolio construction is usually left to the professionals, given its complexity. Historic investment returns data is used to suggest the mix of assets most likely, statistically, to maximise risk-adjusted returns. The theory is far from bullet proof, however, because it has to rely on past data to predict future results and it also assumes investors are rational. The ‘modern’ label is somewhat misleading too, given that MPT was first developed in the 1950s.
It is only with hindsight that we find out how different assets gained, or lost, value. If you could predict future investment performance accurately, portfolios wouldn’t be necessary. You’d just buy the asset generating the biggest returns and sell before it slipped. You’d win every time!
But as we don’t know what the future holds, a portfolio is there to create a ‘team’ of investments with a clear objective and suited to the task at hand. Crucially, this team must weather hard times as well as good.
To return to the footballing metaphor: it isn’t realistic to win every game during the season; what matters is where you end up in the League at the end.
When you choose investments, you can’t know how well they will perform.
Money Advice Service
Rising numbers of individual investors are taking a more hands-on approach to managing their assets.
Rough-and-ready model portfolios designed by champions of passive investing. Think of the lazies as a show home – a useful source of ideas for building your own portfolio.